Why Do Earnings Go Up? 7 Forces That Drive Earnings Up

Why do earnings go up?

We discussed in part 4 of this series that the earnings of the S&P 500 have continued to grow over time, although not in a straight line. Sometimes the economy hits a rough patch and the earnings of the S&P 500 do fall. However, the S&P 500’s earnings have always recovered and eventually reached new heights.

There are specific forces which actually drive earnings up over time; sometimes they work together and sometimes they don’t. Below are the seven forces that drive earnings up:

• Inflation
• Productivity
• Innovation
• International expansion
• Population Growth
• Acquisitions
• Stock buybacks

Each of these forces usually has a small impact on earnings of 1 to 2% in any given year, however in some years they become more significant. When these forces are combined, they are the reason that earnings rise over time.

What is inflation?

Inflation is when the price of goods and services rises over time. Currently, countries worldwide are struggling with rapidly growing inflation caused by various political, economic and social factors. You’ve probably experienced it firsthand, when comparing how much you paid for goods 20, 10, or 5 years ago, versus today.

The price for almost everything you could buy then —food, clothes, cars, houses, gasoline and healthcare is significantly higher today.

Inflation occurs because money slowly loses its buying power over time. Businesses raise their prices each year to offset the loss of buying power, which causes their earnings to increase each year as well.

What is productivity?

Productivity is simply getting better at making or producing something. Productivity is when we find new ways to produce more goods and services with the same or less input.

To break it down for you, inventing new technologies, developing new techniques, sourcing more sustainable and environmentally-friendly materials —all of these contribute to productivity. Productivity means becoming better at creating goods over time.

This is amazing news because what it really means is that businesses produce goods like food, cars, electronics or agricultural technologies more efficiently. This leads to increasing their margins or passing their savings on to consumers, which grows their earnings over time.

If we look at the chart presenting the United States Government keeping track of productivity, you’ll notice right away it’s been on a rising trend since 1950. As usual, there have been some rough moments, but the long term trend is that productivity goes upward.

To paint some color, in the 1900s, 41% of the U.S. workforce was employed in agriculture, while in the year 2000, after hundreds of technological milestones, it was only 1.9% of the employed labor force that worked in agriculture.

What is innovation?

Innovation is when new types of goods and services are brought to market that open new possibilities for businesses. Humans invent new technologies constantly, and every now and then, there’s momentum when such technologies open up new market opportunities that previously didn’t exist.

What is key to grasp, is that companies need to adjust their practices and processes to these innovative events, sometimes milestones. Whether they are startups entering markets or existing companies with long traditions, they all need to compete against each other to create products and services that meet the new demand on the market. Only then can they continue to grow and make profit.

Examples of those milestones are: Cryptocurrencies, Artificial Intelligence, 3D Printing, Internet-of-Things, Digital Wallets, Cybersecurity, Online Learning, Online Dating, Robotic surgery, Electric Vehicles, Space Tourism, Solar Roofs,Waste Recycling, Wireless Charging and many, many more.

What is international expansion?

Nowadays, companies are fully aware they need to catch up not only with their local competitors, but also with globally spread competitors if they want to scale their business fast. In the times of worldwide access to the internet, companies focusing on subscription, licensing or content creation business models should consider international expansion to grow their business.

Let’s look at Netflix, which was founded in 1997 and right away introduced an innovative idea of renting DVDs through the mail rather than through rental stores. Then, in 2010 it was already in the process of transforming from a DVD rental business to an online streaming platform. This move introduced Netflix to a large number of new international markets, like Latin America or Europe, which led Netflix to gain over 200 million subscribers worldwide, by 2020. And guess what? Half of them lived outside the United States.

Whether your business is based online or offline, globalization and quick and accessible transportation services still enable businesses to reach a whole other level of expansion possibilities. This is how you can see that brands are known and popular in different continents, regardless of their place of origin.

The world’s largest economies are the United States, China, Japan, India, and Germany, with others developing and growing fast, which proves that there is an undeniable potential for businesses to expand their activity abroad and enter new, rising markets.

What is population growth?

In 1900, there were 1.6 billion people on our planet. In 2020, the total population grew to 7.8 billion. The projections say that by the end of the current year 2022, the world’s population is going to reach 8 billion people. The United Nations estimates that by 2100 this number will reach 10.8 billion people.

This is a lot of growth in population, don’t you think? There’s more to it taking into consideration globalization and how it affects the world into a more connected and interdependent place.

In the context of entrepreneurship and looking to expand your business, you can see that the number of potential consumers grows. Each and every product and service has its own target group. However, taking into consideration the accessibility of entering new markets, you can see that the potential for opening new store locations, building and outsourcing new factories or selling your products and services online to a limitless number of customers has never been this high.

What are acquisitions?

Let’s get back to our example of Best Coffee Shop, which decided to use its profit to open up one new store each year. The reality is that opening up a new store from scratch is difficult. First owners Natalie, Ethan and Lauren would have to find the right spot, then build the store, organize the equipment and interior, hire the right employees, get supplies, and don’t forget about doing a ton of paperwork along the way.

Don’t you think that it would be a lot simpler to buy an existing coffee shop and rename it with the Best Coffee Shop brand instead? This action would be an acquisition of a business!

An acquisition is when one company buys the majority of another company’s stock in order to gain control of it. It also involves financial perks, like the fact that the acquirer gets to count all of the acquiree’s revenue and profit as its own, which grows the acquirer’s revenue and profit as well.

Other reasons for acquiring another business could be:

• to gain control over its assets
• to increase market share
• to gain access to a new technology
• to enter a new market
• to decrease competition
• to lower costs
• to diversify the number of products that are available for sale
• to gain employees

Acquisitions have become more and more common in the business world regardless of the industry. In 2020, American businesses spent more than $2.4 trillion to acquire more than 15,000 companies.

What are stock buybacks?

Looking at our example, after Best Coffee Shop went public each of the owners Natalie, Ethan and Lauren had their ownership position cut in half. Natalie owned 30%, Ethan 15%, Lauren 5%, and the remaining 50% was divided among the public investors who purchased stock.

Since there are 20,000 shares in total and Natalie, Ethan and Lauren own 10,000, this means they own half of Best Coffee Shop, and public investors own the other half. If Natalie, Ethan and Lauren wanted to gain more control over the company, they would have to have a larger claim on the company’s profit and assets. The way they could get it, would be reducing the number of shares that public investors own, which is called stock buyback.

A stock buyback is when a company repurchases its own shares from its investors. Some companies decide to use a portion of their profit to buy their stock back from their public investors, and when it happens, the number of shares that exist declines. It leaves all remaining shares with a slightly larger piece of the business.

So let’s imagine that Natalie, Ethan and Lauren decided to use some of their profit to buy back 5,000 shares of stock from public investors. Before the buyback there were 20,000 shares in total and after the buyback there are only 15,000 in total. This means that each remaining share has a larger claim on Best Coffee Shop’s profit, which makes each share more valuable.

So, after completing the buyback, Natalie still owns 6,000 shares of stock, so her ownership position in the company would rise from 30% to 40%. Ethan still owns 3,000 shares , so his ownership position would rise from 15% to 20%. And Lauren still owns 1,000 shares , so her ownership position would rise from 5% to 7%.

The very same principle is applicable to the stock market as a whole. Every year, companies in the S&P 500 spend billions of dollars on buying their stock back from investors, which reduces the total number of shares outstanding and in turn, the earnings per share increase because the total number of shares goes down.

Stock Market 101 is a series of videos and articles meant to help you take first steps in investing with understanding and clarity. Read the next part all about the magic of compounding.